About the state of economic science, and advice from a famous economist

Summary: an economist explains the current state of the science of economics, and then Bruce Bartlett repeats to us the most-famous modern economist’s advice about a similar situation.

Excerpt from a post by Prof Brad DeLong (Economics, Berekeley) at his blog Grasping Reality with Both Hands. It is so perfect that it needs no elaboration:

The problem is that economic theory is not rocket science. It is not like theoretical physics — conducting a relatively few crucial experiments to decide on basic theories and then working out the consequences of those theories from first principles. Economic theory is, instead, crystalized history. We take a bunch of historical episodes that seem relevant to the problems of interest of today. We boil down what seem to be their salient features. And then from the resulting soup and bones we construct simple stylized models that we think help us understand present and future episodes that fall into the same class.

The problem is that right now we have a financial crisis big enough and strange enough that there is only one past historical episode in the same class: the early stages of the Great Depression. And when there is only one, the value of skill at deriving theoretical lessons from the class is at a steep discount and the value of knowing the history is at a premium: better to take the history raw.

What would Keynes advise us to do?

His post discusses an article I recommend reading: “What Would Keynes Do?“, Bruce Bartlett, Forbes, 5 December 2008 — “The government should spend on stuff, not on bad assets.” Excerpt:

Every day that goes by makes clearer the parallels between the current financial crisis and the one that led to the Great Depression. Then, as now, the core problem was one of deflation, or falling prices. But fixing it will require more than just low interest rates. This was the key insight of British economist John Maynard Keynes, whose theories finally explained how to end the Great Depression. They may be the key to solving today’s crisis as well.

The Great Depression was so deep and prolonged for many reasons. Herbert Hoover stupidly signed the Smoot-Hawley Tariff, which crippled international trade and finance, and imposed one of the largest tax increases in American history in 1932, which was exactly the wrong medicine at the wrong time. Franklin D. Roosevelt at least understood that deflation was at the root of the problem, but he thought artificially raising the price of gold and preventing businesses from cutting prices and wages by law was the solution. In fact, it prevented the economy from adjusting, which made the situation worse.

{I will skip over his analysis, which is succient and excellent, and jump directly to the conclusion}

Keynes argued that the only thing that will really work is if the federal government uses its resources to purchase goods and services. It must buy “stuff”–concrete, computers, paper, glass, steel–anything as long as it is tangible. In other words, the government must spend the way households do, by buying things.

It must also employ labor, because much of what people spend money on today is in the form of services. This doesn’t necessarily mean putting workers on the federal payroll, it just means that, to the extent that the government purchases services, this will also help raise spending in the economy.

We will know that the government is spending enough to matter when interest rates start to rise. Although we think of saving as coming in financial form, in reality, saving represents things–labor and raw materials that are used to produce products and services people want. Once the federal government increases its purchases of goods and services, it preempts resources that private businesses would otherwise use in production. As they compete with each other for those resources, their prices will rise and interest rates will rise.

At this point, Federal Reserve policy will become effective again. As prices and interest rates rise, the liquidity trap disappears and money begins circulating more rapidly; i.e., velocity increases. This is what ends an economic crisis. Unfortunately, it was not until World War II that the federal government spent enough on real resources–because they were needed for the war effort–to make Keynes’ theory work in practice.

The challenge for Congress and the Obama administration will be to devise a spending program that draws a significant amount of real resources out of the economy fast enough.

More analysis follows of various solutions — also valuable to read.

Bruce Bartlett is a former Treasury Department economist and the author of Reaganomics: Supply-Side Economics in Action and Impostor: How George W. Bush Bankrupted America and Betrayed the Reagan Legacy. Here is his Wikipedia bio.

FM comments on this

While sensible, this article sparks the following train of thought.

Economics has been one of the most common undergraduate majors for several generations.

This is Econ 101, the primary lesson from the major economic events in 20th century American and global history.

One of the top experts on the depression era has been Fed Chairman throughout the entire crisis.

Why should this article need to be written? This message should be as necessary to say as “don’t pee upriver of your water source.”

Any answers?

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16 thoughts on “About the state of economic science, and advice from a famous economist”

I think part of the reason it needs to be written is that for most of us things like bond, currency, swaps and other markets are things that take place high up in the stratosphere of Wall St skyscraper country, with trillions flowing around from computer terminal to terminal across nations, timezones and currencies. They are arcane, remote, unfathomable.

This sort of article helps to remind everyone that when all is said and done we are still talking about production (of goods and services) whose interplay involves mutually enforcing flows of supply and demand.

I only pray that it really is that simple underneath and/or that the system can auto-correct back to being in line with the underlying foundations of a society’s economy, which will including fostering that which needs to be fostered and eliminating that which needs to be eliminated so that some sort of natural balance can return. Given the overwhelming complexity of the many inter-related and now international factors, this is perhaps similar to the problems we have in understanding the root elements of climate. Although on some level nothing is simpler than sunshine, cloud formations, rain and plant growth, understanding and managing them properly seems often elusive to those living within a complex, urban environment versus the more natural rural one (of yore). So it seems our global economy is similarly such an urban type of matrix making it hard to identify the fundamentals that apply in the original crude rural roots that are now beyond the ken of most of the participants.

Even Bernanke said the government could always choose inflation over deflation by dumping money out of helicopters if need be. This won’t work if people take the helicopter money home and hoard it. Buying stuff is the secret of increasing aggregate demand. If no one else, Bernanke can benefit from this article.

Why did this article need to be written? Because in the soup and bones of modern economics there is still much room for obfuscation and sophistry in service of elite agendas. Why do I feel the need to respond? Because other, preferable paths exist within the space of plausible solutions that come out of the soup and bones of modern economics.

This article seems to me to miss the point as much as any other. Deflation (falling prices) is indeed a problem because it increases the value in goods and services of the enormous debt that exists throughout the economy, effectively further increasing the debt burden. The government taking on public debt to print and spend money to inflate the supply of money in circulation to drive up prices to reduce the value of the debt while causing some to be paid off is a plausible solution, but one with serious, unnecessary side effects: centralization on an unprecedented scale of the economy, with an equally unprecedentedly large new public debt, and devaluing the savings of those who chose to save just as it devalues the old debt, creating a tremendous moral hazard.

The genius of Keynes was finding this totally centralized solution to the problem, an idea made thoroughly unpalatable by the side-effects; the genius of Irving Fisher, his contemporary {Prof Economics at Yale}, was to develop and exposit the theory of a similar decentralized solution that was emerging on its own and operating successfully at the time, local scrip programs with demurrage charges (negative interest) to promote circulation, which come with no such problems. Fisher’s solution is one we owe it to ourselves to consider if we wish to avoid the terrible prices of Keynes’. Fisher’s book on the subject is available online here: “Stamp Script” (1933).

What of the system that caused the debt to accumulate in the first place? A debt-backed currency co-creates increase in debt with increase in the money supply, which drives up prices, which devalues savings, which requires more debt to maintain standards of living. Our task is to adopt a system that does not have such a feedback loop as a feature. Commodities-backed currencies operating in tandem with mutual credit systems, with no leverage permitted anywhere, constitute such a system.

So the solution is for the federal government to use money borrowed from China to buy goods made in China, and then use up the unused, languishing shipping capacity of the world’s fleets to ship them to third world dumps, thus keeping the major institutions alive, while minor, non-critical institutions are allowed to fail.

Minor non-critical institutions like individual economic actors (people) will of course be expected to endure shortages of raw material (food, shelter) and markets for productive capacity (labor) so that the major institutions (banks, governments) keeping the system alive can survive.

Clearly this is the best way of dealing with the problem.
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.Fabius Maximus replies: No. A “fiscal stimulus” means buying US goods and services, to maintain US aggregate demand. No all spending provides a fiscal stimulus.

Let’s also recall the reason the housing bubble popped — TOO MANY HOUSES. There was massive mal-investment of scarce productive resources into a market that was saturated. Altho it only became saturated in 2006 — from 1982 thru 2006 there was only a few local bumps in what seemed like a never-ending rise of house prices that allow and justify more house building.

My current solution: the gov’t should lower taxes, AND lower borrowing (from the Chinese or anybody), but increase spending. By literally printing money.

The gov’t should give everybody $5000 or $10 000 of free spending money. [Or give everybody an optional credit card with an ARM of %1 per year and a borrowing limit of $5000 (my preference).] The buyers should be the US consumers. So THEY ‘buy stuff’, and THEY decide, in buying, which companies should be prospering and which ones need to change their business models.

All the Big Banks with $tr exposure to derivatives should be allowed to die thru a pre-packaged Chapter 11 bankruptcy, firing the board and the top executives and all who got big bonuses, as well as firing most of the bank workers. Deposit holders get their cash back thru FDIC and deposit bailout, but investors only get pennies on their dollars, after the derivatives are unwound. Welcome to ‘market regulation’.

There are too many bankers, just like there were too many house-builders. If 500 000 builders can lose their jobs, and hundreds of construction companies go under, then having 500 000 bankers lose their jobs and have the worst 100-800 (10% of 8 000) go under is something the economy can adjust to.

(Hey Retarded, you might be the spokseman the elite are looking for, but you’ll have to change your handle. :) )

The news of the town’s prosperity in the midst of depression-ridden Germany spread quickly. From all over the country reporters came to see and write about the ‘Miracle of Schwanenkirchen.’ Even in the United States one read about it in the financial sections of most big papers.

… “Numbers of people found employment and in some places prices rose. Wara worked for those who believed in it.

… With war inflation still fresh in memory, the government was apparently unable to see the difference between the kind of inflation which begins at the level of the ground and aims at the sky, and the modest Wara which began at the bottom of the pit and aimed back at the threshold – without ever getting within shouting distance of it. Under a misconception, therefore, – one of the most common of monetary misconceptions, – the German government imagined that it could detect in Wara the threat of evil – evil to come out of good; and at last the government succeeded in stopping the good. It forbade Wara by means of an emergency law (3) “As a result,” (writes Mr. Cohrssen), “Schwanenkirchen and other towns where Wära have provided the life blood of economic activity are on the dole again.”

As to the spread of Wära through Germany, not more than 20,000 Wära circulated at any one time. Yet it was said, during 1930-31, that 2 1/2 millions of people handled it. Accordingly, many observers believed that the amount issued was far greater than it was.

Tom Grey: I think one should consider also WHY there were too many houses. Having hollowed out the manufacturing base thanks to wage arbitraging which benefits the corporate balance sheet in computer terminals at the expense of local citizenry on national earth, wages were dropping considerably (also thanks to women being fully in the workforce therefore doubling labour supply and halving salaries). People kept consuming, mainly in order to have their home, widely regarded as more or less the sine qua non of fulfilling the ‘American Dream’, including groceries, heat, accessories, two cars and so forth. Sure, there were excesses in consumption and stupidity in borrowing, but 70% of the nation’s wealth being in 1% of the wealthiest tranche tells a different story, not to mention 10% well below the poverty line.

The house became both for the financiers and families pretty much the only way to make or save money. Unfortunately for the savers it also became a speculative vehicle as the values moved up and increasingly the main source of credit as incomes (relatively) went down.

So the surplus housing supply cannot be examined in isolation any more than the efficiency of a car manufacturer. (For example, I would love to know the full story behind GM’s scotching of the Electric Vehicle and Exxon’s buying the patent for it – how could such a thing have occurred and be allowed?)

When you include housing wealth, I’m not at all sure that 70% of the US wealth was in the wealthiest 1%, yet while the actual details do matter, your point about excessive concentration of wealth is quite good.

Which is why I now oppose all financial bailouts — that’s the easiest way for the undeserving rich (like Fannie Mae ex-pres.) to keep more cash than they deserve.

Yet aggregate demand DOES need to be supported against deflation.Krugman says that monetary theory takes a hit because the 1% limit is being reached, and I think this is most correct in terms of a paradigm shift.

The success of Friedman’s monetarism enabled a fairly stable expansion of production leading to a bubble of mis-production AND excessive debt ‘everywhere’. When inflation re-ignites in the future, I’m sure monetarism limits and increased interest rates will be successfully used to reduce it, again.

Until then, the issue is how to maximize employment in the least socially costly way? I claim, with no proof, that the gov’t printing money is better than borrowing it or taxing it or doing nothing. And it’s probably something like the Wara (but will have to read it later.)

There should probably also be a GI Housing Bill to let veterans get special downpayment support in buying a house now.

Erasmus: You write, “So much for Schwanenkirchen and Wara.” You might have noticed the similar story in the United States, where the local currencies were banned by executive order to clear the way for the New Deal. Bernard Lietaer tells the story this way in his book Community Currencies, excerpt here from Chapter 7 – Historical Precedents:

Stamp Scrip in North America

Emergency currencies have a longer history in America than most people realize. They seem to appear with a curious regularity– the 1830s, 1890s, and 1930s–coinciding roughly with the bottom of the long-term economic cycle called the Kondratieff wave. I will concentrate on the last period because it is the best-documented example.

The theoretician behind the movement in the United States in the 1930s dwas Irving Fisher of Yale University. He had analyzed the Woergl case in Austria and published various articles about its success. Subsequently, more than 400 cities, and thousands of communities or organizations all over the country, issued one form or other of emergency currency. Many were stamp scrip, involving the application of a stamp at prescribed intervals (monthly, for example). There was also a movement to issue this stamp script officially nationwide: Senator Bankhead of Alabama presented a bill to the Senate February 18, 1933, and Representative Petengill of Indiana presented a bill to the House of Representatives on February 22, 1933.

During this time Irving Fisher approached Dean Acheson, then Undersecretary of the Treasury, to obtain support from the Executive branch for the same idea. Acheson asked the opinion of one of his Harvard professors, who advised him that the system would work but that it would imply strongly decentralized decision making, which he should check out with the President. Soon thereafter, President Roosevelt prohibited any use of “emergency currency” and announced the New Deal centered around a grandiose centralized plan of large construction projects.

These examples all show that the concept worked in the modern world whenever it was allowed and correctly implemented.

We should hardly be surprised that the central banks and their beneficiaries in government and business would do all they could to protect the bank monopoly on money and credit. Nonetheless, enduring examples of community currencies exist to be emulated, most notably in my mind, the Swiss WIR, which has operated continuously since 1934.

Spartacus, thanks again. For some reason, I find this topic/aspect fascinating. At the same time, it is not surprising at all that anything undermining increasingly centralised structures is soon quashed.

In that vein, I am personally convinced that we need to resurrect some functional equivalent of the Emperor/Monarch paradigm wherein the more vast the power vector (in this case total) the more limited the executive/managerial control (none). Ideally. Which hardly ever happened. Another way of putting it is that the higher up the power pyramid one goes, the less physical/direct access to the tangible. For example, the agency that sets a law – which binds all members – does not administer it only write it. There HAS to be centralised power in any group, but how it is channeled is the key, and I don’t think we have any handle on that at all these days.

The stamp scrip system is for me a very powerful example of how a national problem that became one because of over-centralisation can be solved by applying tactical fixes on the local level. I am convinced that, as unfashionable as it is, this sort of locally based paradigm needs far greater emphasis in general, and not only in the realm of monetary policy. The relations between local community, regional and national need substantive overhaul.
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.Fabius Maximus replies: An example of local action during the 1930’s were “penny auctions“.

Some farmers in Madison County, Nebraska, took matters into their own hands. In 1931, about 150 farmers showed up at a foreclosure auction at the Von Bonn family farm. The bank was selling the land and equipment because the family coundn’t repay a loan. The bank expected to make hundreds, if not thousands of dollars.

As those who were there remember it, the auctioneer began with a piece of equipment. The first bid was 5-cents. When someone else tried to raise that bid, he was requested not to do so – forcibly. Item after item got only one or two bids. All were ridiculously low. The proceeds for that first “Penny Auction” were $5.35, which the bank was supposed to accept to pay off the loan.

The idea caught on. Harvey Pickrel remembers going to a Penny Auction where “some of the farmers wouldn’t bid on anything at all – because they were trying to help the man that was being sold out.” At auctions across the Midwest, farmers showed up as a group and physically prevented any real bidders from placing bids

An excellent, simple article providing some sort of overview from Stiglitz, one of the best: “Capitalist Fools“, Joseph Stiglitz, Vanity Fair, Janaury 2009 — Stiglitz is a Nobel Prize-winning economist and professor at Columbia University. Conclusion:

The truth is most of the individual mistakes boil down to just one: a belief that markets are self-adjusting and that the role of government should be minimal. Looking back at that belief during hearings this fall on Capitol Hill, Alan Greenspan said out loud, “I have found a flaw.” Congressman Henry Waxman pushed him, responding, “In other words, you found that your view of the world, your ideology, was not right; it was not working.” “Absolutely, precisely,” Greenspan said. The embrace by America—and much of the rest of the world—of this flawed economic philosophy made it inevitable that we would eventually arrive at the place we are today.

Now I think that is as good a tactical overview as we’ll get.

Spengler’s piece dwells several levels deeper in macro-historic zones whose essence and developments lie far beyond policy prescriptions; such things take decades, if not centuries, to evolve (or devolve as might currently be the case).

Is such an unconventional concept as “charge money” a theoretically sound one? The answer is a resounding yes, and is supported by economists of no lesser stature than John Maynard Keynes. Chapter 17 of Keynes’ General Theory of Employment, Interest and Money analyzes the implications of such money, and provides a solid theoretical backing to the claims made by Gesell. Keynes specifically states: “Those reformers, who look for a remedy by creating an artificial carrying cost for money through the device of requiring legal-tender currency to be periodically stamped at a prescribed cost in order to retain its quality as money, have been on the right track, and the practical value of their proposal deserves consideration.(note 5) He concludes with the prescient statement that “the future would learn more from Gesell than from Marx.” (note 6) The second part of his statement is now accepted fact. Might he also be correct on the first part?

So even the Man himself approved it seems. From Chapter 6 – “The Validity of ‘Booster’ Currency” (source)

From the Bartlett article relating to velocity – and therefore the scrips subplot here:

Another problem that policymakers back then didn’t grasp is that the money supply’s effectiveness depends on how quickly people spend it; something economists call velocity. If velocity falls because people are hoarding cash, it may require a great deal more money to keep the economy operating.

Think of it this way: Velocity is the ratio of the money supply to the gross domestic product. If GDP is $10 trillion and money turns over 10 times per year, then $1 trillion in money supply will be sufficient. But if velocity falls to 9, a $1 trillion money supply will only support a $9 trillion GDP. If the Fed doesn’t want GDP to shrink by 10%, it will have to increase the money supply by 10%.

This is essentially the problem we have today. Unlike in the 1930s, the Fed is not allowing the money supply to diminish. Also, we have programs like federal deposit insurance to prevent bank deposits from shrinking. But velocity is collapsing. Banks, businesses and households are all hoarding cash, not spending except for essentials. This is bringing on the deflation that is crippling the economy.

Erasmus: I’m always glad to find the appreciation of these issues broadening.

I agree completely with the sentiment in your comment 12 above, restated from my own perspective, that the American people (if they are the rest of your ‘we’ as they are of mine) have forgotten everything they needed to remember into the 20th century about the importance of decentralized institutions to democracy, that centralized forms of social organization, while sometimes expedient, should always be limited in duration and scope to the achievement of a similarly bounded purpose, and about the economic order generally doing much more to shape the political order than vice versa, the absolutely fundamental role of economic institutions in determining the character of public life.

Recognizing these points, I believe that the first step in the overhaul you mention is the sort of monetary reform to which I am pointing in all my quoting in these comments.

As for your comment 13, I must differ a bit. The sentiment against the free market in general seems only to abdicate the responsibility of determining specifically what was the problem with all of what was going on, andor lay the blame upon a vulnerable scapegoat. The opposite of a free market is a centrally planned and regulated system, which is the only thing that unqualified and unelaborated criticism of the free market can suggest as a solution, which is certainly the wrong solution to our current problems, despite the self-aggrandizing determination of everyone with a prominent voice in the matter to pursue this course. It was the opportunities for corruption inherent to the centralized system that permitted the constraints on the system to be bent, broken, and redefined as convenient for the elite.

We know much more about what happened and how it might have been prevented – all of the problems Stiglitz mentions are about one thing: debt-money being created out of thin air and then thrown around in speculation. The list of regulations proposed to deal with this in all its forms reads like the construction of epicycle after epicycle to describe an elliptical trajectory – formally adequate as an approximation, perhaps, but a dead end. At the center of everything was the enormous leverage permitted by the system that let speculative bubbles and risk grow and metastasize. To criticize this specifically would be meaningful and useful. But, because leverage, at least qualitatively, is fundamental to the current paradigm, this would risk bringing the discussion too close to the recognition of the Fed as the prime enabler of the bubble-blowing and of the bankruptcy of the paradigm of monetizing debt in a partial-reserve banking system. The admission of the so-called capitalist fool is not an example of courageous or chastised humility, but of yet more dissimulation and opportunism in the guise of ideological progress.